The Dow Theory is named after Charles Dow, co-founder of The Wall Street Journal, and creator of various stock averages, whose editorials formed the basis for the philosophy. Dow really created the idea of technical analysis and price action.
Just to refresh you, there are six basic guidelines to the theory. In no particular order, first, Dow said that a trend continues until something happens to stop it – occasional moves in the opposite direction don’t mean that the trend is over, they are just market noise.
Secondly, trends are confirmed by market volume. I think this is an important lesson that we can overlook when we just follow the prices. Often you may find a temporary reversal, but if you look, you’ll find that there wasn’t much trading that day, and so the move is not an important indication of sentiment.
Third, there are three stages to a price trend, whether up or down. For a bullish trend, the first stage, called accumulation is when not many people are interested in the stock. The ‘smart money’, or those in the know, are buying without much effect on prices. The second stage is when other people, through following trends and technical analysis, are ‘catching on’, and the price rises. This is a public participation phase, and is driven by greed. Thirdly, this leads to excessive speculation, and prices reach a plateau, with clever investors starting to sell.
You can also have the reverse happen. That is, at the start the investors ‘in the know’ are selling stock quietly, against the general opinion of the market. They re-alize that the value of the stock is weakening. The price is fairly constant because not many people are trading. In the second stage the market catches on, and with greater participation the price changes quickly. This move is driven by fear. Finally, when despair sets in, no one wants to put money in the stock, and the stock bottoms out for lack of interest.
The fourth factor in Dow’s writings was the observation of the way mar-kets move. Primary moves are those that show the underlying trend, and can last a long time, maybe years. Secondary moves go the other way, usually for a few weeks or months, and these are called corrections in a rising market. We can also see some times that prices move almost randomly for a few days, which are a dangerous time to trade, being unpredictable.
Dow also supported the idea that the market prices in all information at any time. This is sometimes called the ‘efficient market hypothesis’. You may have seen when a company announces good earnings, and the stock price drops, which may not be what you would expect. That’s because the market anticipated the news, and it was al-ready priced in. They have a saying “buy the rumour, sell the news” in Wall Street, which refers to this seeming anomalous observation.
Lastly, Charles Dow was very interested in the relationship between the industrial average (DJIA) and the transportation average (DJTA). He always said that these two indicators had to be moving together to confirm that a trend is real and should be believed. What one makes, the other takes. In other words, if companies’ shares are going up, but transportation isn’t, then the rise in value is suspect, because the goods aren’t being delivered and giving transportation shares a boost. Similarly, if transportation is going up, but the industrial average is down, something isn’t quite right. What is driving the transportation index up if there are no more goods to move?